Thoughts on AIG

19 March 2009 at 10:53 am Peter G. Klein 10 comments

| Peter Klein |

Nothing has annoyed me more in the last 24 hours than the constant parade of angry, self-righteous, and ill-informed denunciations of AIG coming from Capitol Hill and the mainstream media. No one, of course, likes the thought of a failing, taxpayer-supported firm paying large bonuses to executives. But let’s talk some common sense here.

The main lesson is that AIG should never, ever have been bailed out with taxpayer dollars. I said that at the beginning, and I stand by it even more today. AIG should have declared bankruptcy. Under bankruptcy there are well-established, orderly procedures for winding down a firm, distributing the remaining assets among the various legal claimants, and so on. Injecting taxpayer money without any serious thought about the implications of government subsidy and/or ownership for management and governance is just plain dumb. Naturally, that’s what Congress and the last President — people who know exactly zilch about what companies do and how they are run — did.
Performance-based pay is a complicated subject. There are dozens, if not hundreds, of theoretical and empirical studies on the effects of performance-based pay on company performance, the benefits and costs of various compensation formulas, and the like. As Jensen and Murphy wrote back in 1990, “It’s Not How Much You Pay, But How.” Of course, the people screaming the loudest right now haven’t a clue about any of this.
If I were a bank or private-equity investor putting money into a struggling firm, I would certainly want a say in management — not just one or two ad-hoc, politically correct issues like executive pay, but all aspects of organization and governance. I might well want to increase the firm’s use of variable pay. I might want to increase the size of certain bonuses, if that helps me attract and retain better managers. Of course, it depends on labor-market conditions, the performance of my firm relative to other firms in the industry, the nature of the previous compensation contracts, and so on. The key question: Does paying a particular bonus increase or decrease firm value? I haven’t heard a single grandstanding pol or mainstream journalist come remotely close to asking, let along answering, this question. No, it’s all about “greed” and some bloviating Congressman’s moral outrage.
As an outside investor, I certainly would not have the right to renege on whatever prior contractual arrangements I happen not to like. I can’t pick and choose, willy-nilly. Employees, contractors, suppliers, bondholders, etc. all have contractual claims on the firm, and my infusion of cash doesn’t allow me to ignore these without legal consequences.

Craig Pirrong has written one of the few sensible commentaries on this (not counting prior O&M posts here, here, and here). Writes Craig:

There are legal provisions under which contracts can be modified (e.g., bankruptcy). If they apply here, then by all means proceed. Unlike the . . . proposals ricocheting around Capitol Hill, these mechanisms embed various procedural protections, require rigorous fact-finding, and can draw upon a variety of precedents. All of these reduce the likelihood of legal error. If these do not apply, then let’s speak no more about it. . . .

One sentiment (I won’t dignify it with the words “thought” or “idea”) that I’ve heard is that since the government now owns AIG, it can do whatever the hell it wants. Uhm, no. A firm is a nexus of contracts, and if you acquire it, you acquire the entire bundle. Not just the contracts you feel like living up to.

Craig also points out that even given the government’s objective (saving the firm), infusing cash to meet creditors’ collateral requirements was exactly the wrong way to do it.

Update: Lynne’s comments are good too.

Entry filed under: - Klein -, Bailout / Financial Crisis, Corporate Governance, Public Policy / Political Economy.

Management Theory and the Current Crisis Sarasvathy Slides

10 Comments Add your own

1. Per Bylund | 19 March 2009 at 11:16 am

A slightly different view is presented on Roderick Long’s blog by Jennifer McKitrick. I’m curious as to your thoughts on her approach to analyzing this mess.
2. Peter Klein | 19 March 2009 at 11:27 am

If I understand her argument correctly, I think I disagree with it. She says:

“Even if this were the case, how would you feel if millions of taxpayer dollars that was intended to help save their companies was used to give them bonuses instead? Myself, personally, would still not be happy about it. (I find it implausible that the bonuses, in the current environment, actually help the company be more profitable.)”

The part in parentheses is key. Whether or not paying these bonuses improves company performance is the main question in all of this, a question that requires analysis and argument, not just the writer’s intuitive hunch.

“So why are the bonuses so horrible? In my opinion, it’s because they constitute the transfer of vast sums of wealth from millions of Americans who can’t afford it to a privileged few, which serves no other purpose than the interests of the few (who also happen to have been a lot better off in the first place).”

I agree that the transfer of millions from taxpayers to AIG is a moral outrage, but this has nothing to do with the bonuses per se. The money used for the bonuses would have been spent anyway. If AIG had not paid executive bonuses, but used the money to increase wages, build a new building, pay off bank debt, or throw a big Christmas Party, would McKitrick say that’s OK? The moral issue, in my view, is the total amount of money given to AIG, not the specific ways in which AIG spends that money.
3. REW | 19 March 2009 at 11:35 am

Since contracts are (evidently) sacred, can we track down and punish all the citizen/taxpayers who walked away from their contractual mortgage obligations and, thereby, contributed to the scale of the toxic real estate assets?
4. Per Bylund | 19 March 2009 at 11:48 am

Yes, I mostly agree with you Peter even though economics could certainly use some philosophical depth in its analysis sometimes.

In this case, however, the point is what REW’s comment implies: one cannot choose to ignore contractual obligations simply because one dislikes them, and do that just because one assumes the right through adding funds to that existing nexus of contracts. This is a very real danger of the bailouts and, especially, the political rhetoric in its wake. Suddenly (well, maybe not very suddenly) the enforceability of contracts is subject to political correctness and the willingness to make short-run political profits.

Just like REW points out, the mortgage obligations people walked away from are as contractual as are the bonuses. The enforceability of contract is condemned by the political elite in one case, and undermined (and inefficient contracts even subsidized) in the other. “Contract” has become a very relative concept.

But I suspect this is but the beginning. What is interesting is what this may lead to in terms of legislation and new legal interpretations. And this is where [moral] philosophy becomes a very important part of economic analysis.
5. Steve Phelan | 19 March 2009 at 3:25 pm

Here is another take from a comment by Russ over at The Tipping Point

“I used to be confused about the cult expressing itself in terms like “best and brightest”, “talent”, “innovation” being used in ways that clearly had no relation to the English language.

This was obviously an Orwellian ideological language, but it took me awhile to figure out that the key is that all these terms are being used in a corporatist, not even a capitalist, sense.

Therefore, whereas innovation normally refers to creating some new real value, and talent refers to innate ability at some real endeavor, here innovation refers only to finding new ways to seek and collect rent, the talent referred to is that of a con man, and the pivotal figures are the lobbyist, the lawyer, the PR flack, the captured regulator, the corrupt politician.

I don’t doubt they’ve been so immersed in this ideology for so long they have come to completely believe in it, and are incapable of seeing anything from any other perspective.

This also goes to the inability of this administration to look at things any other way. Whether one’s gut response to these AIG bonuses was, “this is unconscionable, these contracts are on their face invalid, let’s figure out how to fix this, but fix it we must and shall”, as opposed to “contracts are sacred, and we can’t do anything about it”, is clearly a matter of ideology and political will.

(By now strict legalities have nothing to do with the matter.)

That’s why the exemplary adminstration response was Summers blathering about the “rule of law”, how we can’t “abrogate” and so on. This is because he’s a hard-core ideological warrior for corporatism and has dedicated his life to enabling looting operations like this one.

He may deplore, on a tactical level, the brazen shoddiness of this particular extraction. But he cherishes this basic outcome. So of course he’s going to claim it’s a legal fait accompli, when it is in fact no such thing.”
6. Mike Sykuta | 19 March 2009 at 9:52 pm

Per,
That was pretty much the argument I made in a blog here on 3 Feb. That post was specifically in response to the pressure Citi received to walk away from its naming rights deal to the Met’s new baseball stadium and the fact that they actually did break a deal for a new jet.

It is clear in the current political climate that a contract is only as good as its populist political value.
7. David Hoopes | 19 March 2009 at 11:40 pm

REW: It’s not that contracts are sacred. They’re legal documents supposedly entered into voluntarily. The problem with allowing select contracts to be broken is the same as allowing select people to break any laws. The second half of your comment hits on this. If they can break their contracts why can’t I break mine. Sorry, I realize you were being tongue in cheek, but there it is.

Steve: I’d say the same thing. It’s not sacred, it’s law. And the last thing we need is politicians more overtly skating around the law than they already do.

ALSO, what about all the money going to European banks? The executive bonuses (which I agree are obscene) are chicken feed to all the money we sent to our friends across Europe.
8. Peter Klein | 20 March 2009 at 4:39 am

Right, there’s also the effect of arbitrary contract breach or renegotiation on expectations. See Bob Higgs’s excellent work on regime uncertainty during the 1930s:

http://www.independent.org/publications/tir/article.asp?a=430

Would you invest in a financial-services firm under the current political climate? Would any competent executive agree to work for one?

It’s the old rules-versus-discretion debate. Even if these specific bonuses were illegitimate — and I don’t think we know this one way or the other — the long-term effect of breaking contracts at will needs to be taken into consideration.
9. REW | 20 March 2009 at 12:55 pm

There is an interesting incipient paper in this thread. We may or may not see the institution of bonus/contracts in the financial sector continue as a result of the changes in the environment. Such incentives may reappear in a different form. Richard Scott’s 3 pillars of institutions (or their legitimacy) are in conflict now with regards to these performance bonuses. They may be regulatively legitimate (contract law), but it seems that they are not normatively legitimate any longer. Cognitive legitimacy is the interesting pillar (see Peter Klein above). Will the financial sector really codify these bonuses as orthodox in the near future or will the mimetic process lead to a politically (normatively?) correct outcome of no contractual bonuses?
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